If there is an ‘it’ thing in investing today, it is ‘income’ products. You don’t have to look far to find the reasons. Bond yields, even adjusted for inflation, are pitifully low. Dividend yield on the overall market is still stuck at generational lows and capital gains are hard to come by. So, when BMO introduced a Covered Call Canadian Banks ETF (ZWB) early this year with a mouth-watering targeted yield of 9%, it was met with intense investor interest. In less than six months since its introduction, ZWB has gathered $280 million in assets. This week, we’ll take a closer look at ZWB and a clutch of covered call ETFs from Horizons AlphaPro.

What is a Covered Call or Buy Write Strategy?

Covered Call Writing is a conservative options strategy that allows investors to earn extra income from their stock portfolio by writing (i.e. selling) call options. A call option gives the buyer the right to buy a stock at the strike price any time before the expiration date. In exchange for earning options premiums, investors are giving up some of the upside of their stock holdings. Check out The Rookie’s Guide to Options by Mark Wolfinger for an excellent explanation of the Covered Call Strategy. You can also learn about this options strategy on the CBOE website.

Benefits

The obvious benefit of a covered call strategy is that it allows investors to earn extra income from their portfolio by selling covered calls. The premium income plus the dividend yield of the underlying portfolio would be very attractive to an investor relying on her investments for income. Another benefit, at least according to this study by Ibbotson that looked at historical performance of a covered call strategy, is lower portfolio volatility. An ETF allows investors to take advantage of a covered call strategy without having to implement it themselves.

Downsides

By its very definition, a covered call strategy limits the upside potential of a portfolio in bull markets. Investors who are in their accumulation stage will likely prefer the tax advantages and lower cost of buying-and-holding plain vanilla stock index ETFs.

In tomorrow’s post, we’ll take a closer look at the Ibbotson study that analyzed past performance of the CBOE S&P 500 BuyWrite (BXM) Index.

Further Reading

This article has 21 comments

You’ve hit the nail right on the head. In order to write a covered call, you have to own the security, so, presumably, there is a stock portfolio in the fund. As a result, you have the downside risk of owning stocks in a bear market. And you’ve already identified that the upside is limited because if the call options are exercised, then poof! The stock is taken out of the portfolio.

What you have to ask yourself is whether that yield is sustainable over the long run and how safe is your principal investment. I would suggest that the yield is not sustainable and you do have all of the downside risk of owning the equity without as much upside potential.

This to me sounds like the financial services version of a “make work” government project.

@Phil S: Covered calls don’t offer much of a protection in a down market. But you don’t necessarily have to give up the underlying stock. As I understand it, you can buy back the call option or settle it in cash.

The Ibbotson report finds that writing covered calls provided returns comparable to a long-only portfolio at a much lower standard deviation. It also explains why it expects the trend to continue.

I think writing covered calls makes a lot of sense for someone withdrawing from their portfolio. I’m not sure it is worthwhile for accumulating investors especially in taxable accounts. Yes, volatility of a covered call strategy appears to be lower but I wonder if it is just a function of giving up volatility on the upside (which is a nice problem to have).

@Millionaire: I was looking at PBP last night. Are there other ETFs that you are aware of and interesting to have a look at?

@CC
I analysed DPD, FFA, LCM, MCN, PBP and compared them with DIA and SPY on the 2008-present period.

PBP is by far the worst of this group (but see below how it still competes with the indices) with an annual return of -1.6% (all my returns include dividends) compared to SPY with a return of -0.8%. PBP only has a 1.3% yield and back at the beginning of 2008 didn’t have any dividend. DPD is by far the most interesting with+3.8% annually compared to DIA with a return of 0.6% thanks to a yield of 8.3% (10%+ at the beginning of 2008). FFA returned 0.8% annually with a 7% dividend (10.37% at the beginning of 2008). LCM returned -0.2% with a 8.8% dividend (10% at the beginning of 2008). MCN returned -0.3% with a 8.4% (12% in 2008) dividend.

What’s interesting with these US covered call etfs, except for PBP, is the fact that their dividends were reduced a bit but stayed in the 8-9% range up to today.

Also when I analysed how these covered call etfs did in 2008 (worst year) and 2009 (best year), I noticed that depending on the one you choose they can be more or less volatile than the index:
2008 2009
SPY -34.0% +26.4% (SP500 index)
DIA -29.1% +22.3% (DJ index)
LCM -37.8% +53.9%
MCN -33.4% +59.2%
FFA -30.8% +44.9%
PBP -27.2% +23.9%
DPD -10.4% +29.0%
(all returns included dividends)

Based on these past numbers (and not on fundamental analysis which I haven’t done yet) DPD is definitely a champion closely followed by FFA and MCN if you want to reduce risk in your portfolio and have a better growth than the indices. Let’s hope the Canadian covered call etfs are as interesting.

Count me out on these things. Simply not enough data to understand how they behave in down markets, up markets or ones that go sideways. Staying away from these ETFs, probably makes me a dull and boring investor, but I’m OK with that.

CC i am surprised to find you writing on the nature of covered call strategies since you have said several times that you never trade options. The actual verb you use has a pejorative nuance to it. You normally state that you don’t “dabble” in options, thus implying that the practice is frivolous & distasteful.

you also voice the common outsider’s belief – it’s also often the belief of new option traders – that any stock that has risen higher than its call option strike price must, inevitably, be assigned.

” … a covered call strategy limits the upside potential of a portfolio in bull markets. Investors who are in their accumulation stage will likely prefer the tax advantages and lower cost of buying-and-holding plain vanilla stock index ETFs.”

the Ibbotson study you are citing deals with one strategy alone, out of hundreds. It deals with one-month at-the-money covered calls. I for one regard this strategy as something for addicts only.

it’s possible to earn the same premiums by writing calls farther out of the money plus a few otm puts. These calls & puts rarely get assigned. Optionable stocks are senior stocks. Most of these trade in a band most of the time. The option trader is continually harvesting premium from near the top & bottom of the band.

in bull markets, some of the stocks in the portfolio will rise into the money. In bear markets, some will fall. Only a small proportion will ever be at risk of assignment at any one time. The investor will bypass assignment by rolling the position forwards & upwards, or downwards if a put in a bear market. These are usually credit spreads. There are other, fancier, strategies that i won’t get into here. The point is, out of thousands of option positions, assignment in a well-managed operation might occur a mere 20 or 25 times.

meanwhile, the investor participates 100% in every advance of the underlying portfolio. If you & he were to hold the same etfs or the same stock, both would advance identically. Both would collect all of the dividends. The difference would be that the option writer would also collect an endless stream of tax-favoured option premiums. If he works his option adjustments right, these premiums will equal the dividend income.

next, i’m not sure what you mean by “the tax advantages” of holding stock index ETFs. Options are usually tax-favoured capital gains, so the option writer does have the best tax advantages.

as for costs, i’m currently paying .27% of the portfolio per annum in commissions. That’s lower than many ETF mers.

@humble_pie: My interest in CC option strategy is due to the introduction of new ETFs employing this strategy. I’m very much interested in whether these ETFs are suitable holdings for buy-and-hold investors.

Options are zero sum games — your gain is a loss for the trader on the opposing side. When I first started looking at these ETFs, my initial suspicion was that the extra premium income earned by these ETFs would incur a cost in capital gains. The Ibbotson research confirms this. BXM (at least for the time period of the Ibbotson study) provides comparable returns to S&P 500. What’s interesting though is that it provides returns comparable to S&P500 but with much lower volatility. That’s very interesting.

Most of BXM returns is via premium income. Most of the returns of the S&P 500 is via capital gains. If we assume that CCW strategy and the underlying portfolio provides comparable returns, an investor who is accumulating assets in a taxable account should prefer the latter. Even though BXM’s premium income is considered capital gains, it is ongoing compared to simply buying and holding the S&P 500.

@Millionaire: Thanks for your comments. It appears that a lot of the ETFs in your comments are not directly comparable to PBP.

LCM & MCN are actively-managed closed-end funds. The MER and turnover are just atrocious. The funds also trail the S&P500 for the five-year period ending 5/31. 1.19% in NAV terms compared to 3.24% for the S&P500 index fund for LCM. MCN is even worse. It gained just 0.95% in NAV terms over a 5-year period ending 3/31 (2.63% for the S&P 500 over the same time period)

FFA is also a closed-end fund. 5-year returns at 3.46% are comparable to the S&P 500.

Looking at 5-year returns, DPD seems only to be marginally better than DIA. DPD’s 5 year return (5.5%) almost matches that of DIA (5.04%).

PBP does seem to be a good ETF. It does a good job of tracking BXM. But as you note, distributions are tiny and the whole point of the covered call strategy is to earn extra income from the portfolio.

I don’t find these securities all that appealing, especially since I hold a large part of my US stocks in taxable accounts. I think I’m going to simply stick with VTI.

i continue to assert that this pair of articles & the above reply are seriously skewed. The skew is coming from a writer with a long-declared bias against options combined with a sincere desire to treat the dismal subject right, but nonetheless it’s a skew that contributes little to the understanding of HEX & other call option funds.

in the first place, the comparable BXM & its related study is not the right comparable. It’s an extremely simple nearest month, 30 day option strategy. Whereas HEX goes out 60 days or longer, according to the prospectus. Premiums will be higher & numerous strategies can be employed.

secondly, the BXM study assumes a machine-like repetition of the same strategy every single month, with no deviation, for nearly 16 years. That’s all that an ivory tower, dry-as-dust academic study can do. Whereas the HEX manager has a vast repertoire of strategies available & will, presumably, use them all, including strategies to bypass & prevent assignment. According to the prospectus HEX can hold derivatives, futures, short & synthetic equity positions. It’s theoretically possible for HEX to hold none of the underlying stock whatsoever, for example, as long as the fund holds adequate proxies to hedge the short calls.

utilization of strategies permitted by these broad possibilities will permit the HEX manager to workaround & prevent assignments, and to preserve gains in the underlying stocks, if he chooses.

third, the stated underlyings or deliverables are too unlike to be used in a comparison. One is a fixed S&P 500. The other is a selected basket of 30 canadian large caps with human choice, ie brookfield was omitted & magna was included. Nothing in the prospectus limits the continued exercise of this choice by the HEX manager.

HEX options are all US but the currency is hedged. Hedging will act as a slight drag on revenue.

fourth, the author writes that “options are a zero-sum game.” This is a meaningless phrase with a sneering or pejorative nuance. The identical assertion is constantly made about stock markets in general. Option market-makers can & do issue new options whenever appropriate bids or offers appear, just as companies can & do issue new shares from time to time, so the quantity of both exchange-traded stock & exchange-traded options is not fixed. It is meaningless to claim that every counterparty to an option trade is automatically a loser, just as it would be meaningless to claim that every opposing transaction in a stock market is a loser.

fifth, the blog author writes that gains in stock index etfs are capital gains, whereas gains from selling options are some strange new taxable income beast that he calls premium gains. Within a sentence or 2 he does allow as how premium gains are indeed taxed as capital gains. Such verbiage is also meaningless. The revenue authorities in canada do not recognize any kind of income known as “premium gains.” They recognize capital gains, and the selling of options, when it’s handled properly, gives rise to capital gains.

the fact is that, in its short life, holders of HEX have done slightly better, when they include their distributions, than holders of the nearest equivalent all-stock etf, which would be XIU.

i for one think it would have been helpful to have asked mark wolfinger or another noted option expert to write about what the HEX manager is really doing. True insight would have been helpful, rather than slanted opinion.

as things stand, none of us will ever know what the HEX manager is doing until the first official 6-month or full-year report of holdings is published. Even then, we will not get a clear picture because the manager will jump into more conforming positions just in time for the official snapshot to be taken, as all derivative fund managers do.

unfortunately, so far in this blog, what we have is the blogmaster as the blind leading the blind.

If we talking covered call writing BXM’s past performance is entirely meaningful. In fact, Mark Wolfinger refers to it in his discussion of covered call writing in his book, which is where I learnt about BXM in the first place. Yes, BXM employs a rules-based options strategy. So, what? Stock market indexes are supposed to be “ivory tower”, “dry as dust” too. Funny, precious few fund managers are able to beat these simple indexes.

“It is meaningless to claim that every counterparty to an option trade is automatically a loser, just as it would be meaningless to claim that every opposing transaction in a stock market is a loser.”

If you made a winning trade selling call options, your counter party made a losing trade. Both of you cannot make a profit.

“gains from selling options are some strange new taxable income beast that he calls premium gains”

I don’t know where I said “premium gains”. So I’m not sure your comment is warranted.

“the fact is that, in its short life, holders of HEX have done slightly better, when they include their distributions, than holders of the nearest equivalent all-stock etf, which would be XIU”

And the fact is, HEX has made two distributions that would amount to 3% of the initial value in the first 2 months. Assuming XIU and HEX will have comparable returns, such high ongoing income will generate hefty tax hits in non-registered accounts.

Thanks for your reply. To me the most important is what’s in my pockets NOW. So big juicy yields is what i’m looking for so I can cash these returns now and do whatever I want with this cash, and not just make gains on paper and cash a big loss whenever I’m ready to sell. Plus I think they are great in an RRSP or RESP. Closed-end, open-end, low or high MER, low or high dividends, these are all factored in these returns and I see that at the end of the line if i invested in these CC ETFs I would have made more money than if I invested in the indexes (SPY, DIA or VTI). Also everything I read so far about CC ETF’s say that they are a lot less volatile in bear markets (+ according to my stats, they return more in bull markets), and CC strategies reduce risk, etc. etc. so I have a hard time understanding why it wouldn’t be a good way to invest. They’re not like nebulous etf’s, dangerous. These strategy have been around for years, have been proven and these funds are managed by banks we all know.

@Millionaire: Fair enough. I concede that investors looking for income may want to take a closer look at CC ETF products. But they do have to make sure that they will end up with total returns comparable to traditional long-only holdings.

it’s unfortunate that an expert such as a former pit trader – there are a few in canada – was not invited to present an unbiased insight into the nature of the new call etf funds. What you are publishing are blackwashes. These are personal opinions crossed with broadsides & a marginally-applicable study, plus a fair amount of inaccurate & pejorative verbiage . This isn’t the CC whom i’ve come to know & respect over the past couple of years, so i’m left wondering what is going on.

the BXM study is not particularly meaningful for canadian call option funds because it deals with a US index underlying and with 30-day ATM or one-strike-above-the-money options only. The HEX fund, to which you have applied the study conclusions as if they are Holy Writ, is a different & more flexible animal with hand-picked canadian stock underlyings plus 60-day calls or longer, along with the possibility of higher strikes. Most importantly, it also gives the manager the right to replace his stock holdings with futures, other derivatives, and short & synthetic positions.

next, most of the distributions are pledged to consist of tax-advantaged capital gains & dividends, but you keep insisting that the new canadian etfs will “convert capital gains into income (1 june)” with “hefty tax bites” meaning, apparently, ordinary 100% taxable income.

as for the reference to “premium gains,” you used this expression on 31 may here on this page, implying first that these are not capital gains and stating next, in a vague about-switch, that they are “taxed as capital gains.” Please do consider that in the eyes of the tax authorities things are either black or white. Option sale income is definitely taxed as capital gains as long as the positions are closed out.

these call option funds were designed for canadians who have already decided that they wish to receive income. The strategy the funds employ is designed to deliver tax-favoured income, and not in nearly a draconian a mode as BXM. I am left wondering why you would berate the choice of an income investment vehicle.

do you also berate yourself every time a dividend or an interest payment arrives in your non-registered accounts ? Do you slap yourself on the wrist for having failed to purchase a zero-dividend zero-distribution investment that would continue to accrue, on paper, capital gains for the rest of your natural life ?

lastly, the nature of the income from these option etfs won’t be known the end of 2011 at the earliest. At present there is nothing to bolster your claim that income from these funds will be unfavourably taxed “high income.”

for myself, i’ve purchased a trial amount of HEX & ZWB because i don’t practice the same strategies they are employing, so i’m curious to compare their returns with my own over the next year or so.

i prefer the greater flexibility that comes with options that are 6 months out in time or farther, and with strike prices that start out above & below (puts) market price. This allows the best of both worlds. For example, i’ve owned XIU since 2001, while continually selling calls & occasionally a few puts. I’ve never been assigned. Option revenues over the decade have matched the distributions. Expressed differently, i’ve collected double distributions for the entire decade, with the 2nd portion being tax-favoured capital gains from option sales that a plain vanilla holder can never receive..

during this same decade, XIU has roughly doubled. I still hold every last unit, so i’ve also benefitted 100% from this doubling of the stock. If you wish to cite Holy Writ once again to prove that this is not possible, there’s not much else one can say other than to mention that someone who has never traded options should not imho be holding himself out as an authority.

the sad thing is that not only are you yourself missing an opportunity – you would be an excellent option manager imho – but you’re also trying to discourage others from even attempting to learn.

@humble_pie: I *never* said anywhere that distributions from these funds will be treated as income. I don’t know why you keep repeating something I never said. In fact, this series of posts grew out of a chat with Eden Rahim, portfolio manager of HEX. According to Mr. Rahim, the distributions from HEX will be in the form of tax-advantaged dividends and capital gains.

What I did say is that taxable investors who don’t need the income will take a bigger tax hit than a long-only portfolio in their taxable accounts, which is where I hold all my XIU. HEX has been around for just two months. In that time frame, the fund has made two distributions totaling 3% of initial value. Over twelve months, that’s a 18% rate. Let’s say that rate of distribution is not sustainable and the distributions are of the order of 10%. XIU’s dividend yield is 2.5%. You are getting 4 times higher tax-advantaged distributions with HEX compared to tax-advantaged dividends from XIU. Are you telling me that HEX is more a more tax efficient holding than XIU in non-registered accounts?

Likewise, ZWB and ZEB have posted comparable returns but distributions from ZWB run at 3 times that of ZEB. Yes, an investor eventually has to pay taxes on the capital gains with ZEB but that day could be 20 or 30 years down the line. The difference between paying taxes on the delta every single year and paying taxes on disposition after holding for decades is huge.

HEX can win out over the underlying portfolio only if the covered call writing strategy is not neutral. i.e. the manager is able to exploit inefficiencies in options pricing. That’s active management. Mr. Rahim may be skilled enough to do that. Only time will tell. Meanwhile, active management is not a peg in which I’d like to hang my hat on. You mileage may vary.

” I don’t see a compelling reason to buy into the covered call strategy either. I have no interest in converting capital gains into income.”

won’t you please reread your text & comments. There are several similar passages scattered here & there. I’ve already quoted a couple. They are misleading, as in “I have no interest in converting capital gains into income.” Unfortunately you’ve denied it every time. Not going to repeat.

one can see that you are finally modifying your views, though. Suddenly you are including an important comment from the HEX fund manager, who explains that his fund distribution will consist largely of tax-advantaged dividends & capital gains.

this is vital information that should have appeared in the lead paragraph of the first article on the first day of the series, imho. Too bad it’s hidden here at the bottom of the comments where no one will ever read it.

as far as i can make out, the fundamental mistake you are making is assuming that, in paying out capital gains arising from option sales, the fund is sacrificing an equal part of its future.

i’m happy to agree that there is some merit to this view, but only if one is considering ultra-short-term 30-day at-the-money calls as BXM does. Your point about frequent assignments & frequent transaction costs has merit, but these defects belong mostly to this strategy.

in reality there are a myriad strategies for call writers. The HEX prospectus indicates that it differs widely from the BXM model. I’ve already written about this difference. Not going to repeat. But it’s ignorant to rigidly apply a BXM filter to every covered call strategy.

covered call writers who go farther out in time & higher in strike price, who incorporate other modalities such as pairs or trios of options including puts, who continuously roll over & adjust their positions, will be continually capturing 100% new money from outside speculators, while almost never surrendering any gains that accrue in the underlying stock.

they’ll have fewer transaction costs. They’ll have the best of both worlds. The market value of their holdings will increase far faster than that of the plain vanilla holder.

here’s an example. Investor holds 1000 shares of TD bank. All dividends & all revenues from option sales are reinvested by purchasing additional units. During the course of the year, option investor takes in 6640, being 2640 from dividends & 4000 from 2 call sales & 1 put sale. He acquires 83 new shares at 80 to hold 1083 sh.

option investor’s holding is now worth 86,640. Vanilla’s holding is worth 82,640. The tax cost from capital gains in options to option investor ? a maximum 1000 or less, depending on his tax bracket. It’s easy to see which one is better off.

“the fundamental mistake you are making is assuming that, in paying out capital gains arising from option sales, the fund is sacrificing an equal part of its future”

In your TD Bank example, of course, the investor who sold calls and puts came out ahead. The options never got assigned. There is no evidence that this happens in practice. Every single covered call ETF listed in the US have similar or lower total returns than buy-and-hold and every single one of them have made distributions at the expense of future capital gains. ZWB has been in existence for less than 6 months and already its higher distributions have come at the expense of future capital gains.

Not only is there no evidence to support your claim that option writers “almost never surrender any gains”, according to HEX manager the call options sold on the portfolio have a probability of exercise around 25%. That doesn’t sound “almost never” to me or having the “best of both worlds”.

I don’t think there is any doubt that these options are being assigned on a regular basis. If they were not, that would mean options being sold are “out of the money” which would mean little to no additional income (since these are short term options) … I do think that Covered Call ETF’s can overperform in some circumstances, especially in a flat market but they do have to overcome fees that are higher than standard ETF’s.